Encounter

Daniel Bubis, president and CEO of Winnipeg-based Tetrem Capital Management Ltd., says that he and his team are treading carefully in the Canadian equity market.

About the Author

Sonita Horvitch is a Morningstar columnist who specializes in reporting on money managers and their strategies. A veteran financial journalist, she was formerly with the National Post and its predecessor, the Financial Post. At the Post she was best known as the author of the popular Buy & Sell column, which she wrote from its inception in 1994 to December 2008. She holds a master's degree in business economics from the University of the Witwatersrand in Johannesburg, South Africa.

"It has recovered from its dismal showing in January and still offers compelling value by historic standards, but there are headwinds." The "commodity-price bust" has dealt a hefty blow to the Canadian equity market and the Canadian economy, says Bubis.

"The all-important Canadian energy sector has been hit hard." Although the fundamentals for oil have recently improved, there is still an oversupply in the global market, say Bubis. "This means that the recovery in the oil price is likely to be gradual."

Another cause for caution, says Bubis, is the ongoing uncertainty surrounding the economies in China and other emerging markets. It is hard to forecast what will happen to these economies, he says, so a conservative approach to stock selection is warranted.

Bubis reports that he and his team are putting greater emphasis on large-cap, blue-chip stocks. "Also, in a slow global economic growth environment, dividends will account for an important part of the total return from equities. Dividend payers and growers should represent a significant percentage of a portfolio."

Both the U.S. and Canadian equity markets were weak coming into this year, says Bubis. There was "extreme investor pessimism based on macro concerns." There were fears about the health of China and other emerging-market economies and the potential resultant slowing of the U.S. economy, "which has been a bright spot in global growth." As the year unfolds, investor sentiment is improving, he says. "Strong economic data coming out of the United States has allayed investor fears and their fears regarding China have abated somewhat."

The U.S. economy is currently on track to produce a "slow and steady GDP growth rate of greater than 2% this year, and slow and steady wins the race." By contrast, Bubis notes, Canada's GDP growth outlook for 2016 is more modest at around 1%. Canada's unemployment rate is also higher than that of the United States.

In light of this, says Bubis, "it technically makes sense for the new Liberal federal government to boost its expected expenditure on infrastructure, as outlined in its March 22 budget." The proviso, he adds, is "that this spending is done effectively."

There is undoubtedly value to be had in the Canadian equity market, says Bubis, who is a value manager. Tetrem employs a quantitative measure to assess value in a stock market. The equity team calculates the difference between the valuation of the cheapest 20% in that market and the valuation of the overall market.

The team uses traditional valuation measures such as price-to-earnings and price-to-book-value. "The wider the spread between the valuation of the cheapest stocks in the market and the value of the market as a whole, the bigger the opportunity," says Bubis.

Currently, the value differential in the Canadian equity market is substantial by historic standards, he says. "This is telling us a lot of negativity has already been priced into the Canadian equity market, reflecting the short-Canada theme."

Daniel Bubis

Tetrem Capital Management, with assets under management of $5.1 billion, manages a range of mutual funds for CI Investments Inc., including CI Canadian Investment and CI Canadian Investment Corporate Class. At the end of February, this portfolio held 56% in Canadian securities and cash, 32% in U.S. equities and 12% in international equities. Its biggest sector weights were financial services at 30.5%, energy at 12% and industrials at 12%.

Tetrem focuses on companies with strong franchises in industries with high barriers to entry and that trade at a material discount to the companies' estimated fair value. "We look for a reversion to the mean in both the fundamentals and the valuation."

Since the beginning of this year, Bubis reports that he and his team have been finding select opportunities in a number of areas of the Canadian and U.S. equity markets. For example, the team has added to holdings in Canadian airline stocks and both Canadian and U.S. rail stocks. "I am most enthusiastic about these stocks," he says.

The Tetrem team recently added to the portfolio's holdings in WestJet Airlines Ltd. (WJA) and Air Canada (AC). Bubis says there was a value opportunity in both stocks. "Investors were concerned about the strength of the companies' domestic market, with the focus in WestJet's case on the Alberta economy's weakness." Bubis notes that these two Canadian stocks trade at a discount to their U.S. airline counterparts, which "exemplifies the sell-Canada theme," he says. The fundamentals of these two Canadian airline companies are "solid."

Despite the weakness in the Canadian economy, air travel continues to grow, benefitting from lower jet-fuel prices. The Canadian airlines industry also enjoys the advantage of being an oligopoly, Bubis says. "There is an economic moat and pricing power."

Railway companies on both sides of the border also enjoy an oligopoly, says Bubis. The Tetrem team has added to a long-standing holding in Canadian National Railway Co. (CNR).

Within the Canadian energy sector, "there are high barriers to entry in the pipeline industry." Bubis reports that the Tetrem team added to its holdings in two large-cap Canadian pipeline stocks, Enbridge Inc. (ENB) and TransCanada Corp. (TRP). These two stocks came under severe selling pressure early in the year, he says, following the sharp drop in U.S. energy-infrastructure stocks.

The valuations on Enbridge and TransCanada and their high dividend yields were most compelling, Bubis says. "Furthermore, there is less commodity-price risk than is the case with the energy producers."

Air Canada

Enbridge Inc.

TransCanada Corp.

WestJet
Airlines Ltd.

March 28 close

$8.57

$49.86

$50.10

$19.73

52-week high/low

$15.09-$6.81

$66.14-$40.03

$58.12-$40.58

$30.56-$14.67

Market cap

$2.4 billion

$42.6 billion

$34.7 billion

$2.4 billion

Total % return 1Y*

-32.6

-15.2

-4.6

-32.2

Total % return 3Y*

41.4

4.9

4.6

-5.0

Total % return 5Y*

27.9

14.1

8.7

8.6

*As of March 28, 2016
Source: Morningstar

After Tetrem's addition to the fund's Enbridge holding, the company announced a $2-billion share issue in late February. Bubis notes that TransCanada is also in the throes of a major share issue. On March 17, the company announced a bought deal of $4.2 billion to assist in the financing of its proposed US$13-billion acquisition of Columbia Pipeline Group, Inc. (CPGX). (This bought deal is in the form of subscription receipts, which will automatically be converted into common stock when the acquisition closes.)

Bubis says TransCanada's acquisition of Columbia is a "significant strategic move for the company that recognizes the geographic shift in the natural gas industry."

Tetrem has also been "upgrading its holdings among the energy producers by reducing the number of smaller-cap, higher-risk companies and focusing on larger-cap blue-chip names." For example, the team has increased its holding in Canadian Natural Resources Ltd. (CNQ).

"The market has been myopic about this company," says Bubis. Investors, he says, have been concerned about the capital expenditure necessary to complete the company's oilsands project. "Once this is behind CNQ, it becomes a free-cash-flow generating machine."

Tetrem has also built a bigger position in Crescent Point Energy Corp. (CPG). "The company smartly cut its dividend and can fund its capital expenditure in the lower commodity-price environment."

The team has trimmed its holdings in "two energy stocks that were winners in a tough sector last year." They are the integrated energy company Suncor Energy Inc. (SU) and Tourmaline Oil Corp. (TOU). "These two stocks remain core holdings in the portfolio," says Bubis.

There has been little change in the portfolio's holding in the financial-services sector, "where we already had a substantial footing." An exception, says Bubis, is the addition to the portfolio's holding in Bank of Nova Scotia (BNS). "The stock offered relative value among the banks; Scotiabank's stock came under pressure because of concerns about the bank's exposure to emerging markets."

The Tetrem team remains enthusiastic about the major Canadian banks, says Bubis. "They have strong franchises, solid capital ratios, growing dividends and good dividend yields."

Finally, Bubis highlights the portfolio's holding in Canadian grocery distributor Loblaw Cos. Ltd. (L). The company, he says, is a strong free-cash-flow generator and the stock trades at a discount to other Canadian consumer-staples stocks. "A stock like Loblaw adds important ballast to an overall portfolio."

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